Slow Going...But Going, Still

Dear Investor –

As the late and esteemed economist posing as comic Gilda Radner once commented, “If it’s not one thing, it’s something else!” As Middle East turmoil has shifted back to Greece and the deepening woes in Europe; as Japan slowly pulls life back together after hideous catastrophic events while the US and other parts of the world suffer from the terrible wrath of the climate gods, we find ourselves in much the same global and domestic economic situation as before. Perhaps a bit less sanguine than 3 months ago, yes, but cautiously positive nonetheless.

While the media talking heads and Tea Partiers would have people believe that we’re heading rapidly into the next great ocean of doom, the fact remains that the economy is still growing. Sure, we’re a far cry from the 5-6% growth we’d like to see in a recovery (and Obama would like to see in his hopes to avoid a one-term presidency), and frankly admit that the first two quarters’ annual growth rates of just under 2% is flat-out putrid at best. But with Japan effectively shutting down, horrific climate impacts from floods, drought, tornadoes, European uncertainty, rise in oil prices, contentious budget and debt talks in a Congress (where the inmates in the House appear to be running the asylum), threats of state and federal shutdowns… some might suggest that things could be far, far worse. The fearful cries of “double-dip recession” have vanished long ago into the night. Clearly, with the credit, housing, energy bubbles having crashed at the same time, with the Great Recession come and gone, we’re still standing (yeh, yeh, yeh). Like an adolescent’s room left un-cleaned for ten years, it should be expected to take time to clear out from the incredible mess the nation’s economic room was in.

This year’s international and domestic uncertainty has created a certainty of its own – the incredible swings in the equity markets (which would make a wonderful roller-coaster ride at a major amusement park). Yet despite the ups and downs and curves, the constant stream of annoying and distressing news, mediocre consumer and business sentiments, the markets have been positive all year, averaging around +4% or so, and part of a continuing rising trend since March 2009. From Jan 1 through June 30, the markets were up around 5%, but the equity markets are up nearly 25% over the last year. The domestic bond markets, on the other hand, have been far less volatile, and though annoyed periodically by inflation concerns, they’ve managed to stay slightly, predictably positive most of the year. Then again, compared to a good chunk of the world, the US seems a relatively sane place to be. We, of course, know better.

For those who care to read no further – and we are keeping the reading short, particularly in light of it being beach weather – we’ll cut to the chase about what we think of the coming months: mostly more of the same, perhaps just slightly better. We expect growth to ratchet up to 3% or so for the second half of the year, hardly anything to gush over, and moving up slightly after that. We don’t expect the sky to come crashing down despite European woes. We expect modest improvements in exports, slight improvements in jobs and housing, decent to strong corporate profits. The markets should follow suit.

So, let’s start with the bright side. Exports continue to do well and aided in part to the weaker dollar. Productivity remains very strong. Corporations have very strong balance sheets, loads of cash, and having cleared out much of their debt are now beginning to borrow at low rates for capital investment. Inventories are lean, and orders for big capital goods purchases are now backlogged. Further pickups in manufacturing and auto production should be expected in the second half. Most of the issues with respect to Greece and the European debt issues have been grappled with and built into the current expectations, and Japan – whose economy was stopped dead in its tracks and impacted the US -- is making a strong and noble comeback. China, India and Brazil, while slowing somewhat, should continue strong growth as do the emerging markets generally. And housing -- even housing! -- is showing positive signs particularly in the area of multifamily building, where growth has been extremely robust. We’ve needed more rental housing for years, and now (because people can’t purchase or are being kicked out of homes) we’re finally getting it. And while inflation is inching up slightly, it’s not seen as a significant threat. All in all, not too shabby.

On the shadier side lie a plethora of challenges. First, a major geopolitical event – major natural disaster, unexpected default from a major European nation, an explosion of new events in the Pakistan, India or Mideast – and all bets of stability are off the table. With unemployment having trouble moving off the 9% level (and with over 16% underpayed), fear remains strong. Years of bad behavior – excess credit, real estate bubble, etc. – masked what was really a jobless recovery earlier in the decade, and this unfortunately will continue to be a drag for some time. As a result, as consumers choose (finally) to reduce debt and save, consumer purchasing remains tame at best. As our economy – nearly 70% -- had become consumer-driven, the fall is that much more difficult. And with declining revenues, state and local governments will continue to struggle and throw additional workers onto the unemployment rolls. This unfortunate situation which we foresaw early on in the financial crisis is hopefully coming to an end this year and next.

Rising oil prices – from $80, to over $100, and projected by some to go much higher -- have also been a drag on the recovery. In addition to forcing consumers to trade needed purchases for gasoline, a broad swath of industries have had to deal with higher energy, materials, and transportation costs. And with continuing demand in China and emerging markets, oil and commodities prices are likely to remain high, even though growth in the developed markets is barely moving. This appears to be helping to drive slightly increasing inflation.

Finally housing – a huge inventory of foreclosed homes and weak residential construction remain major impediments. As Dr. Paul K points out, a sustainable new home production level would be 1.2 to 1.5 million units per year. We’re currently at half that, and came from an unsustainable level of twice that. This, he feels, will continue to be a slow grind, with improvements not likely to really take hold until 2012. In the meantime, the good news is that things are not getting worse – the hemorrhaging has stopped.

Let’s be clear – we’re not in the gloom and doom camp. The economy is growing slowly, but is growing. We’re moving forward. Many are suffering, but if nothing else, our economy is resilient. I could opine for many paragraphs on all the ills that were apparent and growing in the economy before the economic crisis took hold, the many poor choices our elected and appointed leaders made in the time after the crisis. The recent and current focus on reducing debt in the face of a shrinking economy was, and is, incomprehensibly short-sighted, when investment was and is so obviously needed. It remains agonizing at times to watch the revisionist history presented by those philosophically entrenched (entombed) in a pit decorated with slogans and bumper stickers espousing ever-smaller government, deregulation, cutting taxes for the wealthy, and eviscerating social safety-net programs, while shunning investment, planning, education, and managing of risks to the economy. Yes, despite all this idiocy, we believe growth will continue, improve, and the resilient economy will prevail.

The markets. We expect the wild ride of the equity markets to continue, particularly through the summer. The headwinds presented by the uncertainties of Europe and Washington DC will continue to toss and tumble investors, as we anticipated over the last six months. Markets could even rally strongly with resolution of these issues. Still, we expect the markets will manage to eke out modest gains for the year after all is said and done. Investors need to be able to look past the day-to-day, however, to maintain sanity. With the arguments for an economy picking up significant steam in mid-2012 fairly reasonable, we might expect the markets to perform well in advance of that. That said, we’re pretty much sticking with our allocations. Dividends remain attractive, particularly given the low interest rate environment. We still take the position that long term prospects continue to look very favorable for strong long term equity performance. For the short term, however, volatility may be a fact of life.

The concerns that fixed income investors have had about inflation-driven rising interest rates have diminished of late as growth has disappointed. However, a lowering in the rating of Treasury debt (currently AAA), substantial increases in interest rates abroad, or a surprising improvement in economic growth could significantly change the picture. Moreover, the difference between higher yielding (higher risk) bonds and higher rated bonds has become smaller, making the former somewhat less attractive. Interest rates remain far below historic levels, however, so investors must remain vigilant about changes in rates, as even a modest rate change could impact current values, particularly longer term maturities. Accordingly, we continue to focus on diverse interest income positions, particularly intermediate term corporate bonds and quality municipals. We continue to see value in high-quality dividend paying stocks which we feel have the ability to perform well in an increasing interest rate environment as well as in an improving equity market. With volatility and uncertainty remaining high, gold and silver remain useful hedges.

There you have it: despite the currently erratic and volatile worlds of both politics and economics, we continue to take a tempered, modest and quietly optimistic opinion of the investment markets and, over time, the economy. As we’ve seen all too often, however, major geopolitical or economic shocks can have profound impacts, so we will remain watchful. Whether investing for equity growth or income, investors should expect some tumult, unless willing to suffer the consequences of nearly-negative returns on money market accounts and other less risky positions. We expect the waters to quiet soon however.

 

Enjoy Summer.

Peace,
Ron Stein

Good Harvest Financial Group
631.423.6501
rstein@goodharv.com